Asset Allocation Using Flexible Dynamic Correlation Models with Regime Switching

The asset allocation decision is often considered as a trade-off between maximizing the
expected return of a portfolio and minimizing the portfolio risk. The riskiness is evaluated in
terms of variance of the portfolio return, so that it is fundamental to consider correctly the
variance of its components and their correlations. The evidence for the heteroskedastic
behaviour of the returns and the time-varying relationships among the portfolio components
have recently shifted attention to the multivariate GARCH models with time varying
correlation. In this work we insert a particular Markov Switching dynamics in some Dynamic
Correlation models to consider the abrupt changes in correlations affecting the assets in
different ways. This class of models is very general and provides several specifications,
constraining some coefficients. The models are applied to solve a sectorial asset allocation
problem and are compared with alternative models.